Thursday, May 29, 2008

A lot of economists right now are saying the increase in oil and food prices are due to the depreciation of the US. Dollar. This depreciation has been attributed as well to the rise of price of gold and many other commodities.

It is true that, since the US dollar is the de facto currency of value of just about everything, its depreciation means that everything is now more expensive when looked at using the USD. Therefore, the lower the USD goes, the higher the dollar price of everything becomes. And the lower the USD goes, investors who used to hold USD-denominated instruments look for alternatuves, such as commodities.

But there had to be a more fundamental cause to all this commodity inflation that we are all finding ourselves in. after all, not everyone lives in the USA, and not every country buys for these commodities using USD.

Many have to buy these commodities by exchanging their local currencies with the USD. And as far as I read about, everybody in the world is finding the price of commodities now very expensive. Everybody! Including those who come from countries with appreciating currencies.

The fundamental reason for the increase in commodities prices is that there’s just more demand for them, and supply is not keeping up.

But I would like to attribute another, and may I add, also fundamental reason for the increase in price of commodities for everyone. I haven’t seen or heard this talked about by any of the economists on TV or print, but I daresay this might be too crucial to overlook.

I think global commodities are very expensive now because China has been keeping its currency too low. Meaning, it has been controlling its currency such that it is now priced below its intrinsic value.

Everybody knows this. It’s been going for some time. But just how has this been contributing to this hyper-inflation we’ve been seeing lately?

Well, China keeps its currency low for one important goal – so that the price of its manufactured goods will remain low when computed by its global customers, and compared to its global competitors. A lower Chinese currency translates to lower price of goods when an American or German buys it. It is cheaper when compared with the Mexican product that can be the next alternative.

So what? Everybody benefits because everybody else gets to buy cheaper goods, right? That can’t be a contributing reason to global inflation, can it?

Well, let’s put this analysis one step further. If the US keeps buying these artificially-low-priced Chinese goods (Artificially-low, again, because of the government-controlled currency), what happens to the US currency?

Well, if Americans keep buying more goods than they are able to sell (because their products are more expensive by comparison), then the US keeps incurring trade deficits. We’ve been seeing this US deficit with vis-a-vis China ever since the turn of this century. So, more money has been going out of their economy than has been coming in. therefore, their currency depreciates.

Conversely, what should now happen to the counterparty to their deficit – China? Well, China has been incurring the mirror-image trade surplus to the US trade deficit. More money has been coming into China than has been going out. And this doesn’t even include the massive capital account surplus that China has been incurring, as investors keep trickling in trying to fund the great China dream of selling their wares to its billion plus population. So China’s currency should have been rising, right?

In fact, it should have risen already to the point that parity should have been reached a long time ago. By parity, the value of their currency should have risen to the point where the equivalent value of a cost of good in China should be the same when compared to an American good made in the USA, where the relatively more expensive cost of production should have been offset by the relatively lower-valued currency.

Has this happened? Not from what any of us has seen. And that’s because the Chinese government intervenes to keep the value of its currency low. The longer they can keep the value of their currency low, the longer their products will seem cheaper when compared to US and other countries’ products the longer they can keep incurring trade surpluses with everybody else.

How does China manage this? Well, you know all that extra boatloads of money that’s been coming into China vis-a-vis what’s been getting out. China has been putting it to goo use (for them, that is investing this money in US Treasuries. In short, they themselves are funding the US trade deficit, by being America’s de facto creditor of the same deficits. Hence, USD has historically maintained its upward value, because China keeps demanding more of it.

Lately, because the American government has been incurring budget deficit in relation with the war in Iraq, and because of the ever-present trade deficits cannot, in reality, be incurred into eternity, the USD has finally been experiencing a downturn.

So we find a world where the USD is going down, but the currency of its mirror-image trading partner, which is still pegged to the USD, remains low.

What’s the implication of this? Well, we see a world where the irrepressible American propensity to consume continues to go unabated, but now it has a new major competitor in the wings – competing for the same scarce world resources – a potentially as-irrepressible Chinese consumer that is only now beginning to afford the same luxuries.

This newly-heightened competition for the essentially same supply of commodities is increasing global prices.

You would think, and I wouldn’t blame you if you did, that because the Chinese government is artificially keeping the value of their currency low, that the Chinese consumer is at a disadvantage – that the value of these commodities, when translated into the low Chinese currency, will be so out of reach for the typical Chinese consumer.

To a large extent, that’s true. There’s a lot of gnashing going on right now in China, perhaps much more than the gnashing going on right now in the US. Only we don’t get to hear them because the Chinese government may be muffling all of it. Or maybe the Chinese are just so used to hardship that they just don’t complain as much.

But to a large extent also, the Chinese government is allowing the Chinese people some leeway by subsidizing the cost of these commodities. After all, if the reason the cost of these goods is so high locally is because of government intervention, it’s only fair that government intervention find a way to alleviate to effects, right?

So again, to a large extent, this contributes to the still-growing demand of the Chinese for commodities. Because they can still afford it - because their government, flush with trade surplus cash – is subsidizing them, the Chinese continue to buy.

The real losers here are those nations whose people enjoy neither the direct subsidy of the Chinese government, nor the indirect subsidy of the same Chinese government, through the purchase of that nation’s Government Treasuries.

That could be you. Now isn’t that a bummer? Down to Chinese currency control!!!

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.